5 Tips ETF Traders Must Know

by on May 3, 2012 | Updated April 25, 2013

The growth of the ETF universe has spawned a number of ways to tap into a variety of asset classes that were previously out-of-reach for mainstream investors. Thanks to the numerous (and growing) number of advantages that ETFs offer over traditional mutual funds, it’s no wonder that the exchange-traded product structure has become the preferred vehicle for many traders; ETFs are useful in implementing any number of investment strategies, ranging from short-term trades to building retirement portfolios [see also Free Report: How  To Pick The Right ETF Every Time].

Nonetheless, these innovative financial instruments are far from foolproof and there are more than a handful of opportunities to make mistakes when trading ETFs. Below we outline five simple, but often times overlooked, tips to consider before executing your next ETF trade:

1. The Trend Is Your Friend

You have probably run across this expression in a financial news article before and you have certainly heard it more than once if you talk to any technical traders. What exactly does it mean? A trend is simply the prevailing price momentum for a given security. In other words, this is the general direction of where an ETF is headed. The trend being your friend simply means that you are better off sticking with the prevailing direction of the ongoing trend (whether it is up, down, or sideways), rather than going against it [see also Five Important ETF Lessons In Pictures].

For example, during a bull market it is recommended to look for opportunities to establish long position, instead of speculating where the so-called “top” is. Likewise, when markets are uncertain and headed downhill, it makes more sense to look for an opportunity to establish a short position or simply stay out of the market rather than try and fight the downtrend.

2. Trade For Free (When You Can)

Aside from the structural cost-efficiencies associated with ETFs, a growing number of products are available for commission-free trading on the most popular brokerage platforms. If you are an active trader, expense ratios are not your biggest concern given your relatively short investment horizon. As such, it pays to shop around before buying into a position. By opting for a commission-free ETF, you can truly maximize your profits by nixing the transaction costs associated with your trades all together [see also How ETF Investors Can Save $415 Million].

There are several hundred commission free ETFs available to respective account holders of the brokerage platforms listed below:

3. Be Mindful When You Trade

This trading tip is perhaps one of the simplest and most commonly overlooked among novice ETF traders. The advice here is simple: be careful when you buy or sell an ETF during the first and last half hour of trading. Why? Because stocks and ETFs alike tend to see relatively higher trading volumes in the beginning and end of the trading session and not as much action mid-day [see also Five Questions To Ask When Buying An ETF].

Higher trading volumes are certainly not a bad thing, however, increased trading activity translates into higher volatility which means wider bid-ask spreads. According to ETF expert Ron Rowland, “this pattern can work either for you or against you. If you’re trying to move a big quantity of shares, you probably want to take advantage of the depth present in the last hour. If you want to trade against someone who may not have thought ahead, you might find some good prices at lunchtime”.

4. Take Advantage Of Limit Orders

Whether you want to trade stocks, bond ETFs, or commodity funds in the morning, lunch time, or five minutes before the closing bell, it’s always prudent to use limit orders. Limit orders are instructions to your broker not to process a given trade unless the price of the ETF is at or better than the limit you define. For example, lets say you have a limit order to buy XYZ at $99.50 a share and it is currently trading at $101 a share; your trade will not be executed until XYZ dips to $99.50 a share or below. Likewise, limit orders are also useful in locking in profits, especially when you are unable to be constantly monitoring your positions.

When using limit orders you define the price you are willing to pay, or sell at. As such, your order may not get filled right away as a market order would, but odds are that you will get a better price by being patient and waiting for the given ETF to hit your intended price target [see also Ten Common Mistakes Every ETF Investor Should Avoid].

5. Use The Right Tools

With over 1,400 ETPs to choose from, it’s no easy chore to find the product which best suits your goals and risk preferences [try our Free ETF Screener]. For ETF investors, it makes sense to give significant weight to factors like expense ratios and portfolio diversification when choosing between different funds to include in a long-term portfolio. On the other hand, for ETF traders, factors like average daily trading volume and the availability of options trading are much more relevant [see also 25 Things Every Financial Advisor Should Know About ETFs]. The ETF universe is filled with all sorts of tools, so it’s important to do your research and pick the one that best suits your needs.

This tip is fairly straightforward; when shopping around, make sure you have a specific investment objective in mind. ETFs can be very powerful tools if used correctly, however, they can also be abused as with any financial instrument. For example, think of a leveraged ETF as a chainsaw; this product is perfect if you are looking to cut down a tree. On the other hand, if your goal is to slice bread, this sort of tool will more than likely leave you with a handful of injuries.

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Disclosure: No positions at time of writing.